Foolish Games

April 20, 2009 at 12:54 pm (By Maxwell James)

In the news today: PepsiCo has apparently offered to purchase two of its largest bottlers for a cool $6 billion, 17% above their market price.

Those of you who haven’t religiously followed the financial markets for the past fifteen years may be wondering: “Why doesn’t Pepsi actually own its bottlers already?” Good question! The answer is that over a decade ago, Pepsi followed its rival Coca-Cola in selling off all most of its bottling operations, while keeping enough equity shares to maintain control over these companies.

The reason? Thanks to a number of factors including agricultural subsidies, fructose water with bubbles is a much more profitable product than glass or plastic bottles with said product in them. By “outsourcing” bottling, the soda companies could post extraordinary profits (for a number of years, Coke’s return on assets averaged 18%), thereby attracting increased investment and vigorously expanding their marketing and R&D efforts. All the while keeping the massive bottling plants – whose annual depreciation costs would otherwise constitute a massive sinkhole in the corporate profits – off the books. The continuing equity stake minimized the impact of these losses, while still giving Coke and Pepsi’s corporate headquarters a high level of control over the actual decision-making at these operations.

At the time, this was actually something of a financial scandal – you can read more about it here for the gritty details. It never really amounted to much: everything they were doing was legal if not exactly kosher, though it tied more than a few investors’ brains into knots. But it made for an excellent Harvard Business School case study, and was a primo example of the late 90’s craze for outsourcing everything that’s not essential – even if it is, in fact, essential.

So Pepsi’s announcement today may very well signify the end of that particular era, and one form of financial shenanigans that characterized it. It’s not surprising that Pepsi rather than Coke would be the first to move on this – their corporation is far more diversified in terms of products and revenue streams. And while both companies remain profitable, legal threats suggest that the writing may be on the wall for overly-sweetened fizzy beverages.

~Maxwell

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8 Comments

  1. amba12 said,

    I wonder whether this is distantly related to the notion of acknowledging the costs of things that have been taken from the commons and not assigned any value — from clean water to, well, housework. (Of course, the latter does get assigned value, sometimes considerable, in divorces.) But there’s much talk of the actual, hidden, unacknowledged cost of doing business and how not acknowledging it maximizes the impression of short-term profit and also maximizes long-term collective loss. I don’t know the words for this. Social capital, natural capital?

  2. Maxwell said,

    It is, sort of. In this case at least some of the externalized costs are displaced from Coke or Pepsi to their bottlers, though, which means that the market does recognize them in the aggregate.

    But there are arguably less obvious externalities as well – for instance, the extra work financial analysts have to put in to figure out if Coke really was worth $1.18 for every dollar. Or, more ominously, the possibility that banks without such hardworking analysts might be overeager to finance the soda producer and marketer, but leery of financing the bottlers that make its sales possible (I’m not saying this actually happened, just that it could happen).

  3. mileslascaux said,

    Great idea. Gimp your company for the sake of short-term lustre on the corporate logo. Hide all the risk in a deck of fine print, counting on the nation being too distracted to find it. And then …

    what?

    Pretend the world ends in 2000 and whoever has the highest ROE then wins? Count on the definition of “too big to fail” blowing wide-open enough to include soda pop makers? Leave it to another generation of CEOs to figure out how to kick the can a little further down the road?

    It is a little shot-glass lesson in how the economy goes to hell.

  4. amba12 said,

    EXTERNALITIES. That’s the word I was groping for.

  5. Icepick said,

    The bigger issue is this: The legal and regulatory systems in this country have become so complex that economic wins and loses are determined by who most successfully manipulates the system. Maxwell’s post highlights two such examples:

    (1) Management at PepsiCo (and Coca Cola before them) used accounting and legal methods to artificially inflate the margins at their company. No doubt these managers profitted from this, in the form of stock options, bnouses, increased pay, etc. The losers from this sort of activity are hidden from sight, but ultimately it would be investors who don’t understand how they are being manipulated. Long term investors would suffer the most. This is a classic agency problem.

    (2) Totalitarian minded busy bodies plan on using “the system” to punish or shut down a company whom they dislike.

  6. Icepick said,

    What is needed is an effort to create a regulatory- and tax-environment that isn’t so easily manipulated. But that will not happen, as the current system allows those in the halls of power to enrich themselves at the expense of the whole body politic. One doesn’t even need to search for old examples of this kind of thing, as new examples appear daily. Today we have the example of Diane Feinstein lining her own pockets through the budget process. This is pretty standard stuff, and everyone in power (including Obama, through his wife’s work as a director at a hosptial in Chicago) has cheated the government this way. Expect this story to flair up briefly so that the press can pretend they’re the public watch-dog, and then it will effectively disappear. Besides, it’s not like the electorate (one hesitates to call them citizens) wants honest government. If they did they’d quit re-electing the obvious crooks.

  7. Icepick said,

    Hmm, where did Maxwell’s last comment go? Anyway, that was a good idea Maxwell, but you didn’t take it far enough. Make it a 100% tax, and have it apply to all immediate relatives of the elected official, including step-children. Also, a 100% tax on all capital gains during their time in office. No loop-holes allowed for either assessment.

  8. Icepick said,

    Maxwell’s last comment became this post.

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